Are falling oil prices good or bad?

According to Jade Fu, Investment Manager at Heartwood Investment Management, as things stand, the expected boost to the US consumer from falling oil prices outweighs the risks to the energy sector (i.e. declining profitability and the potential for corporate defaults). And that is good news for global growth. With consumption accounting for 70% of US GDP, lower energy costs should translate into stronger US consumer purchasing power, helping to lift US growth expectations over the coming quarters.

However, there are pockets of vulnerabilities in certain areas of the market. One needs to be cognizant of potential stress points in the energy and mining and materials sectors, from both equity and fixed income perspectives. The FTSE 100’s bias toward the energy and materials sector (a 15% market weight) has contributed to its underperformance in the year to date relative to other developed markets. Meanwhile, in developed fixed income markets, the US high yield market has been dragged lower in recent weeks by energy related holdings.

Ripple effects through to energy producing emerging market economies are also being seen. A weak oil price is pressuring the domestic finances of already fragile economies, including Russia and Venezuela. The Russian Ruble has plunged to levels not seen since 1998, while the cost of insuring Venezuelan bonds has sharply increased as a weak oil price increases the risk of social and political tensions. While it is difficult to predict how the oil price plays out, any sustained weakness is likely to have a harmful effect on highly indebted commodity-related sovereign and corporate issuers.

In the near term, lower oil prices are contributing to an environment of good deflation – i.e. stimulating consumption which ultimately lifts prices and growth – as opposed to bad deflation (persistently weak demand and investment). However, going into 2015, the impact of lower energy prices must be watched carefully. In managing risk, Heartwood has avoided the commodity sector this year and hold an underweight to energy stocks within their UK equity exposure. The company has structured their emerging market positioning towards commodity importers rather than exporters, in particular avoiding energy producing emerging sovereign debt (hard currency) and corporate bonds, which are also vulnerable to Federal Reserve tightening and a strong US dollar.